CHAPTER 19. THE GOODS MARKET
IN AN OPEN ECONOMY
I.
MOTIVATING QUESTION
How Is Output Determined in the Short Run in an Open Economy?
As in a closed economy, output is determined by goods market equilibrium, the condition that goods supply
equals goods demand. In the open economy, however, goods demand includes net exports.
II. WHY THE ANSWER MATTERS
The full treatment of short-run equilibrium in an open economy requires several steps. This chapter integrates
openness in the goods market into the Keynesian cross model. To consider the goods market in isolation from
financial markets, the chapter assumes that the interest rate is fixed and considers the real exchange rate a policy
variable. Chapter 20 integrates openness in asset markets into money market equilibrium, then combines goods
and financial market equilibrium into an open economy IS-LM model.
III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS
1.
Tools and Concepts
i.
The chapter introduces an open economy Keynesian cross by adding net exports to the demand for
domestic goods.
ii.
The Marshall-Lerner condition ensures that a real depreciation will improve the trade balance. The
condition, derived in an appendix, requires that the proportional change in relative prices (the proportional real
depreciation) lead to a greater than proportional increase in relative quantities (the sum of the proportional
increase in exports and the proportional decrease in imports).
iii. The J-curve describes the dynamics of trade balance adjustment after a real depreciation. Initially, the
trade balance falls, since the real depreciation tends to increase the relative value of imports. Over time,
however, consumers and firms start buying more home goods and fewer foreign goods (since real depreciation
makes home goods cheaper), and the trade balance improves.
2.
Assumptions
The chapter considers the short-run goods market in isolation from financial markets, so it assumes that the
interest rate is fixed and that the real exchange rate is a policy variable. In keeping with the analysis of Chapter
20, as well as the closed economy IS-LM analysis, a more precise way to state these assumptions is that the home
and foreign price levels are fixed, and the nominal exchange rate is a policy variable. Since the price levels are
fixed, the nominal exchange rate determines the real exchange rate. In addition, production is assumed to
respond one-for-one to changes in demand without changes in price (the AS curve is horizontal at the initial
price), so demand determines output.
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IV. SUMMARY OF THE MATERIAL
1.
The IS Relation in an Open Economy
When the economy is open to trade in goods, it becomes important to distinguish the domestic demand for goods,
given by C+I+G, from the demand for domestic goods, denoted by Z and given by
Z=C+I+G-IM/+X.
(19.1)
The domestic demand for goods is specified as in Chapter 5, i.e., C(Y-T)+I(Y,r)+G. Real exports (X) and real
imports (IM/ε) (measured in units of the foreign good) are given by:
X=X(Y*,).
+ -
(19.2)
IM=IM(Y,).
+ +
(19.3)
Exports increase when foreign income (Y*) increases, since foreigners have more to spend, and when there is a
real depreciation (an decrease in ), since home goods become less expensive relative to foreign goods. Imports
increase when home income increases, since home residents have more to spend, and when there is a real
appreciation, since foreign goods become less expensive relative to home goods. Substituting equations (19.2)
and (19.3) into the demand for domestic goods produces a new IS relation:
Y=C(Y-T)+I(Y,r)+G-IM(Y,)/ +X(Y*,).
(19.4)
Note that real imports are divided by the real exchange rate to convert them into units of the home good.
Figure 19.1 displays graphically the effect of introducing net exports into the Keynesian cross model. The
domestic demand for goods is denoted DD. To derive the demand for domestic goods, first shift the DD curve
down by the value of imports (IM/). The new curve, denoted AA, is flatter than DD, because the value of
imports increases with income. Now add exports to the AA curve to arrive at the demand for domestic goods
(ZZ). Note that exports are independent of income, so the vertical distance between ZZ and AA is constant and
the two curves have the same slope. The gap between the curves DD and ZZ is by construction the trade balance
(sometimes called net exports (NX)), depicted in the lower panel in Figure 19.1. Since the value of imports
increases with income, the trade balance decreases with income. Note that Figure 19.1 assumes that the real
exchange rate is fixed.
2.
Equilibrium Output and the Trade Balance
Equilibrium in the goods market requires that the demand for domestic goods equals the production of domestic
goods, namely that Y=Z. Since this chapter concentrates on the short run, it assumes that production responds
one-for-one to changes in demand (without changes in the average price level). Graphically, equilibrium is
determined by the intersection of the ZZ curve and the 45°-line (Figure 19.2). In general, equilibrium does not
require balanced trade. Figure 19.2 depicts an equilibrium with a trade deficit.
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Figure 19.1: The Demand for Domestic Goods and the Trade Balance (NX)
3.
Increases in Demand, Domestic or Foreign
When domestic demand increases (e.g., G increases, T decreases, or consumer confidence increases), the ZZ
curve shifts up, so output increases and the trade surplus falls. When foreign demand (Y*) increases, the ZZ and
NX curves shift up by the same amount. Output and the trade surplus increase. The increase in imports that
arises from the increase in home output does not entirely offset the positive effect on exports from the increase in
foreign demand.
Note that increases in domestic demand have a smaller effect on output in the open economy than in the closed
economy, because some of the increased income leaksout of the domestic economy through spending on imports.
In other words, the multiplier is smaller in an open economy. A box in the text carries this analysis further and
notes that smaller countries are likely to have larger marginal propensities to import out of income. As a result,
fiscal policy will have a smaller effect on output in a smaller economy, but a greater effect on the trade balance.
The relationship between foreign and home output suggests that policy coordination can be important when
industrial countries as a group are operating below normal levels of output. Governments typically do not like to
run trade deficits, because deficits require borrowing from the rest of the world. In the absence of coordinated
action, an expansionary policy by an individual country in the midst of a worldwide recession will likely generate
a trade deficit (or at least worsen the trade balance), because the increase in income will increase imports.
Coordinated expansions will tend to have less effect on trade balances in individual countries, because imports
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will increase more or less proportionately in all countries. On the other hand, coordinated expansions may be
difficult to arrange. Countries that have budget deficits may be unwilling to consider expansionary fiscal policy.
In addition, once an agreement has been negotiated, each country has an incentive to renege, thereby hoping to
benefit from expansions abroad and to improve its trade balance.
Figure 19.2: Equilibrium Output and the Trade Balance (NX)
4.
Depreciation, the Trade Balance, and Output
The trade balance (NX) is given by
NX=X(Y*,) - IM(Y,)/.
(19.5)
A real depreciation has two effects: a quantity effect (an increase in exports and a reduction in imports), which
tends to increase the trade balance, and a price effect (an increase in the relative price of imports), which tends to
reduce the trade balance. The net effect will be positive if the Marshall-Lerner condition (derived in an
appendix) is satisfied. If so, a real depreciation will improve the trade balance and increase output. With some
qualifications, the Marshall-Lerner condition is usually satisfied in practice, and the text assumes that a real
depreciation will improve the trade balance.
If the government can affect the real exchange rate through policy, then it can use two policy instruments (fiscal
policy and the real exchange rate) to achieve two policy targets (output and the trade balance). For example,
suppose a country in recession had a trade deficit, and policymakers wished to achieve a specific, higher level of
output and balanced trade. Expansionary fiscal policy would increase output, but would also worsen the trade
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deficit. A real depreciation would increase output and improve the trade deficit, but there is no guarantee that it
could achieve the output target under balanced trade. To achieve both targets, policymakers would need a policy
mix. First, they would engineer a real depreciation sufficient to balance trade at the target output level. Then,
they would use fiscal policy to ensure that the economy achieved the target output level. If output would be
higher than desired after the real depreciation, policymakers would use contractionary fiscal policy; if output
would be lower than desired, they would use expansionary fiscal policy. The text includes a table that
summarizes other policy mixes under alternative initial conditions for output and the trade balance.
5.
Looking at Dynamics: the J-Curve
Real depreciations have a dynamic dimension. The price effect happens immediately, but the quantity effects
take time. As a result, the trade balance tends to worsen immediately after a real depreciation, but to improve
over time. In other words, it takes some time for the Marshall-Lerner condition to be satisfied. This adjustment
process of the trade balance—a temporary fall followed by a gradual improvement—is called the J-curve.
Econometric evidence suggests that in rich countries, the trade balance improves between six months and a year
after a real depreciation.
6.
Saving, Investment, and Trade Deficits
The national income identity (equation (19.1)) can be expressed as
NX=Y-C-I-G=(S-I)+(T-G),
(19.6)
where private saving (S) is given by S=Y-C-T. The first equality in equation (19.6) illustrates that the trade
balance equals income minus spending. The second equality of equation (19.6) illustrates that the trade balance
is the excess of private savings over investment plus the government budget surplus. Ignoring the distinction
between the current account and the trade balance, a trade surplus implies that a country is lending to the rest of
the world. The funds for this lending are derived from the two sources on the RHS of equation (19.6).
Since saving and investment are endogenous, equation (19.6) can be a misleading guide for policy analysis. For
example, one might conclude from (19.6) that a real depreciation has no effect on the trade balance, because the
real exchange rate does not appear. In fact, a real depreciation affects saving and investment, because it affects
output. If the Marshall-Lerner condition is satisfied, a real depreciation will increase saving more than it
increases investment, and improve the trade balance.
V.
PEDAGOGY
The open economy saving-investment balance (equation (19.6)) is presented at the end of the chapter. There are
two arguments for placing it at the beginning. First, the derivation of equation (19.6) illustrates that the trade
balance is the difference between income and spending, an intuition that may not be sufficiently emphasized in
Chapter 18. Second, by discussing equation (19.6) before the policy experiments, instructors can include the
effects on saving and investment in the discussion of fiscal and exchange rate policy. This approach will
reinforce the notion that saving and investment are endogenous and that the government surplus is not the only
determinant of the trade balance. To illustrate the latter point, note that the U.S. federal budget deficit declined
over the 1990s, but the trade deficit reached record levels.
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VI. EXTENSIONS
The discussion of policy coordination in the text could be formalized. Suppose the world economy consists of
two countries, home and foreign. The goods-market equilibrium conditions for the two countries can be written
as
Y=aY+F-qY+q*Y*
(19.7)
Y*=a*Y*+F*-q*Y*+qY
(19.8)
where a and a* are the home and foreign marginal propensities to spend out of income, q and q* are the marginal
propensities to spend on imports, and F and F* denote autonomous expenditure. Home imports, given by qY,
equal foreign exports, and home exports equal foreign imports. Assume that initially F=F*, and the countries are
perfectly symmetric, so that Y=Y*. The initial equilibrium is point A in Figure 19.3.
Figure 19.3: Coordinated Versus Uncoordinated Policies
Suppose that point A represents desired or normal output levels for the two countries. Now assume that F and
F* fall by the same amount, reducing output by the same amount in each country, and moving the equilibrium to
point B. Note that the trade balance remains at zero for both countries. If the countries coordinate policy, and
increase F and F* by the same amounts, the original equilibrium will be restored. On the other hand, if the home
country increases F, but the foreign country does not, the new equilibrium will be at point C. Both Y and Y* will
increase, but since point C is above the 45°-line, Y will increase by more, implying that home imports will
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increase more than foreign imports, and the home country will run a trade deficit. In this case, the foreign
country will have an increase in output without doing anything, and its trade balance will improve. Thus, there is
some incentive for each country to let the other country undertake the burden of adjustment.
VII. OBSERVATIONS
Real imports (IM) are measured in units of foreign goods. To revisit the example from Chapter 19, suppose the
United States is the home country and produces only one good, airplanes, and Japan is the foreign country and
produces only one good, cars. The real exchange rate is in units of cars/airplane:
=EP/P*=(yen/dollar)(dollars/airplane)/(yen/car)=cars/airplane.
Since IM is measured in units of cars, IM/ is measured in units of airplanes, the home good. Thus, IM/  is a
proper measure of imports to include in the home real GDP equation, which measures all quantities in units of
the home good. In a multi-good world, the same analysis applies, with “home production baskets” replacing
“airplanes” and “foreign production baskets” replacing “cars.”
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